- Learn about saving for a child’s college or post-secondary education.
- Discover tax-favored plans.
- Learn about tax-free earnings.
- Discover the benefits of Coverdell Accounts.
- Learn about qualified tuition plans.
- Find out how others can contribute.
- Learn about gift tax issues.
- Discover the limitations of tuition gifts.
A common question among parents is, “How might I save for a child’s college or other post-secondary education in a tax beneficial way?” The answer depends on a couple of things. How much do you expect the education to cost? How long until the child heads off to college or a university or enters an apprenticeship program? Once you have the answers to these questions, Fiducial can help! We will inform you about all of the tax benefits of saving for college or other post-secondary education.
Saving for College – What You Need to Consider
The amount of funds required will depend upon whether your child will attend a local college, attend a local college and then transfer into a university, go straight to a university, or begin an apprentice program.
If the child will attend college or an apprenticeship locally, you generally only need to plan for the cost of tuition, books, and other class materials. Your child can live at home, which cuts expenses. The child attending a university, unless it is local, will add housing and food costs on top of substantially higher university tuition. Another factor is whether the student will leave school after obtaining a bachelor’s degree or will attend graduate school for an advanced degree.
When the time comes, your child may qualify for a scholarship or grant. However, you shouldn’t depend on that when saving for college.
College Savings Plans with Tax Benefits
The federal tax code has two beneficial savings plans to use. Neither plan provides a tax benefit to making the original contributions. The benefit is that growth due to appreciation of the investments, if any, and earnings (dividends and interest) are tax-free when withdrawn for qualified education expenses. Thus, the sooner each plan begins, the better, because it will have more years to grow in value.
Both savings plans allow the funds to be used for kindergarten education and above. However, these plans provide tax-free accumulation. The more funds you use for expenses at lower levels of education, the less tax benefits they will provide. You should give careful consideration to using these savings plans for anything other than post-secondary education.
You will gain more tax benefits by front-loading the contributions and thus having a larger amount for which the growth and earnings can be compounded. Also be aware that anyone, not just you, can make a contribution to the child’s college savings plans. So if your child has any well-heeled grandparents, other relatives, or friends who would like to help, they can also contribute.
The two savings plans currently available for college savings are the Coverdell Education Savings Account and the Qualified Tuition Plan, most commonly referred to as a Sec. 529 plan (529 denotes the section of the tax code that governs it).
Coverdell Education Savings Account
This type of plan only allows up to $2,000 in contributions per year. This generally rules it out as a practical method for college savings, other than as a supplement to other means of saving.
Saving for College with the Sec. 529 Plan
This approach is likely your best option. State-run Sec. 529 plans allow significantly larger contributions. Also, multiple people can each contribute up to the gift tax limit each year without being subjected to gift tax reporting. This limit equals $15,000 for 2021. This limit is periodically adjusted for inflation. In 2022, it will increase to $16,000. A special rule allows contributors to make up to five years of contributions in advance (for a total of $75,000 in 2021 and $80,000 in 2022).
Sec. 529 plans allow taxpayers to put away larger amounts of money, limited only by the contributor’s gift tax concerns and the intended plan’s contribution limits. There are no limits on the number of contributors and no income or age limitations. The maximum amount that can be contributed per beneficiary (the intended student) is based on the projected cost of college education and will vary among the states’ plans.
Some states base their maximum on an in-state four-year education, but others use the cost of the most expensive schools in the U.S., including graduate studies. Most have limits over $200,000, with some topping $530,000. Generally, people cannot make additional contributions once an account reaches that level. However, this doesn’t prevent the account from continuing to grow.
Taxpayers do not have to limit themselves to participating in the 529 plan offered by their state of residence. They can shop around for the plan with the best growth potential and highest maximum contribution.
When the time comes for college, the distributions will be part earnings/growth in value and part contributions. The contribution part is never taxable, and the earnings part is tax-free if used to pay for qualified college expenses. In addition, the portion of the distribution representing the return on the contributions, if used for qualified education expenses, will qualify for the American Opportunity Tax Credit. This can equal as much as $2,500, provided your income level does not phase it out.
Saving for College with Gifts
In addition to the annual gift tax exclusion, a donor may make gifts (with no specific dollar limitation) totally excluded from the gift tax when making payments directly to an educational institution for tuition. This includes both college and private primary education.
However, these gifts can only pay for tuition, which does not include books, supplies, or room and board. Payments must be made directly to the educational institution for them to be excluded from the gift tax. Reimbursement paid to the donee will not qualify.
The tuition exclusion is often overlooked yet can be beneficial. For instance, a grandparent can use the tuition gift to reduce their estate while helping a grandchild pay for tuition and giving the child’s parents an education credit at the same time.